There are two different methods insurance companies use to handle the loaned cash value — direct recognition and non-direct recognition. In a non-direct recognition company, the earnings rate on cash value is totally unaffected by any loans against cash value. In a direct recognition company, the earnings rates on loaned cash value are affected both positively and negatively when the cash value is used as collateral.

Below is a transcribed conversation between Todd Langford and participants in The Whole Truth About Money event in which he discusses direct recognition vs. non-direct recognition life insurance companies.

Todd: The question was, what about the difference between direct and non-direct recognition? In getting there, the insurance industry is the competition for everybody else. Everybody else figured that out, they don’t fight each other, they fight the insurance industry. The insurance industry is smart enough for that so they fight each other, my company has got non-direct, you’ve got direct.

We’ve got particular companies that put out all this stuff about how if you are buying any insurance from a company that is direct recognition you are getting ripped off. The reality is direct recognition is actually more fair than anything else. In the end, does it matter? No, it’s just a different way of doing the calculations. This is the way it works and we really need to understand this. If you have a fixed interest rate you have to have direct recognition.

Kim: A fixed interest rate?

Todd: On the loans. Fixed loan interest rate, you have to have direct recognition. This is why, so let’s think through this. Insurance companies, to me, their job is to make it fair for everybody else. We need to take ownership in our life insurance companies and we need to have our clients take ownership in it.

Since I owned my life insurance company at some piece, do I want my insurance company to be profitable or do I want to find some way to get to them? We want to be profitable, right? Is that different from my home owners’ insurance? Do I want my home insurance company to be profitable?

No. They are charging me too much. I own my life insurance company. I want them to be profitable. I expect them to make decisions to make themselves profitable and to make it fair for everybody. So let’s talk about how they do that. Why do I have to pay interest on my own money?

Participants: It’s not yours.

Todd: Right – It’s not my money. So why do clients think that? Because we told them that, exactly. When we use words like “borrow your cash value,” we just told them what – that it’s their money they are borrowing. They are not borrowing their money. Life insurance is a very logical tool if we talk about it in the right way. If you look on the web and you Google life insurance professionals, these guys have 4, 5, 6, 10 designations after their name and they all talk about borrowing your cash value. Is that what we do?

Participants: No.

Todd: How can the public think anything else when we use that kind of language? Why are they confused? “Wait a second, this is so weird, you mean I get to use my money, I borrowed my money out of my policy and it still grows?”

Participants: No.

Todd: But you can see why they think that. That that’s weird, but it’s not weird. If we borrowed against it then we didn’t take it out in the first place, that’s no magic. It’s the same thing if we did that with the CD at the bank. If I put my CD up as collateral and I borrow against it, am I astonished that my CD continues to grow? It should be the same way with my life insurance policy.

But actually, one of the reasons it’s hard for people to do that is because we have a gray column over there, it’s called Net Cash Value. It’s awful because people think that is the amount of cash they have that’s growing. So when they borrow against it they see the net cash value go down, “Oh I must be earning less money.” No, we don’t have a Gross Cash Value column unfortunately, that’s what the earnings are coming off of, not off the net but off the gross, aren’t they?

Let’s go back to the direct versus non direct. Where does the money come from when they make a loan? It comes out of the (insurance company’s investment) portfolio. What does that portfolio do when there’s not a loan against it? Right, it’s their investment dollars that are earning money in the marketplace, correct? So if I have a policy with a life insurance company and my neighbor borrows money and it comes out of the general portfolio and they are charging nothing for it, did my dividend just help pay his loan?

Participant: Yes.

Todd: How do they keep that from happening? They charge him interest and the interest rate needs to be at least whatever the portfolio rate is. If the rate on the loan is not as much as the portfolio rate then guess what? Everybody else is paying for that guy’s loan. The loan rate has to be at least whatever the portfolio rate is. What happens when we have a fixed interest rate?

Let’s say we’ve got a fixed interest rate of 6% and now the portfolio rate is 10%. If the portfolio rate is 10% and they are having to loan money at 6%, what happens to my dividend? It’s not as big as it should have been, is it, if they are getting 6% instead of 10% that they should be getting in the marketplace? With the direct recognition company they can fix that.

Why? Because the individual that gets the 6% rate only gets a dividend of 5 while everybody else gets the higher dividend based on that 10% that they are getting in the marketplace. It fixes it and makes it fair for everybody else. If direct recognition wasn’t there, everybody would be paying that loan.

Participant: But they only get the lower dividend rate on the amount that they borrowed.

Todd: Correct, only against the collateralized balance, absolutely. It keeps everything fair. If it wasn’t for direct recognition it would not be fair. So what happens with non-direct recognition companies? Well, they have a variable interest rate and the ideal of a variable interest rate is it needs to ratchet up as the portfolio does in order to make sure it’s the same.

The problem, though, can be this. They can only I think change that rate a half a point a year. On most companies I know of… when they get the charter for the insurance company in a particular state, the variable rate they have to have a formula for how it’s calculated as part of the charter. They can’t just make a number up, there has to be a formula. Typically, it’s tied to Moody’s.

So let’s say we’ve had this terrible economy that we’ve had. Everything is down, portfolio rates are down. We’ve got variable rates of 4% and all of a sudden the economy gets fixed and we see potential portfolio rates at 10%. What happens to all those loans they have at 4%? They can only ratchet them up half a point a year. Everybody is only paying for those loans until that catches up.

Even though most of the times people criticize the direct recognition idea, it’s actually the most fair. It keeps everything in line. In the long run does it matter? No, sorry, but yet we have to find something to fight against amongst ourselves instead of looking at where the real enemy is.

We hope this was helpful to you! These are the types of discussions we love to have in our trainings.

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3 Comments

Julius Botelho
on July 18, 2016 at 7:11 pm

Thanks Todd, this was the clearest most rational discussion of this subject I’ve ever heard.

After having 3 different carriers and 2 different “industry guru’s” give it a go, I read your piece and finally understand it.

Thanks

Kate4TC
on July 18, 2016 at 7:52 pm

Happy to have helped out!
Todd

Rob McPheters
on July 19, 2016 at 11:54 am

Todd

While you are correct that direct vs non direct is not as big of s deal as some make however I do represent a company that is non direct. The reason companies go direct is because they have more than 10% of assets out on loan. Any company that hits that level will go direct. The difference is if I borrow non direct and pay the loan with interest my cash value will be exactly the same had I never taken the loan. This is a nice feature especially as a business owner. That is not the case on direct recognition policy The cash value will be lower if I take the loan and pay it back similar to a UL contract where they segregate the loan amount and pay the guaranteed interest rate on that amount. Non direct companies also do not control the variable loan interest it is set by the 2 year seasoned Moody’s bond index which does track to the investment portfolios of insurance companies but again it is not something the companies set. This whole deal has come about because infinite bankers and Nelson Nash followers do not understand how whole life works. They will say my dividend is 6 and my loan rate is 4.4 so I make 1.6 and I can make money by borrowing. That is not true the dividend rate is only one of 4 factors in the dividend – mortality- investment return – expenses all go into the formula to create the dividend. They are telling Their clients to stack policies (build and add banks) with same premium dollars max funding and then borrowing 30 days after the policy is issued to buy another with the proceeds of the loan. This is completely false and misleading as is the non direct vs direct discussion. When the loan rate changes this house of cards will fall and I hope they all have their e and O paid up. You only make money by borrowing if you buy something with the loan proceeds and make a profit and pay your loan back with interest. It’s about having access to money , control, proper planning and your Whole Life contract should be the last place you go as it all needs to be in place at retirement and at death. It is a fact that policies with loans lapse at a substantially higher rate than policies without loans. If they have their WAA in place they don’t necessarily need to tap their WL contract. I agree that direct vs non direct is not as big of s deal as is being made but again it is usually the IB folks who spout this garbage trying to recruit others to their firm. Thanks for your insight I do enjoy Reading your opinion and insight.